The Securities and Exchange Commission is about to launch a fact-finding mission probing two of the industry's fastest-growing investment products--hedge funds and exchange- traded funds...

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The Securities and Exchange Commission is about to launch a fact-finding mission probing two of the industry’s fastest-growing investment products–hedge funds and exchange- traded funds (ETFs).

Harvey Pitt, the SEC’s chairman, informed attendees in June at the Investment Company Institute’s (ICI) annual shindig in Washington, D.C., of the regulator’s plans to scrutinize some of the “sketchy” issues surrounding hedge funds. They include fraud, questionable marketing tactics, and conflicts associated with managing the funds in tandem with mutual funds.

Pitt’s quest to root out potential evils in hedge funds begs the question: Is he really maneuvering to get Congress to give the SEC more authority over these unregulated investments? Industry officials I spoke with say Pitt is surely jockeying to wrangle more regulatory muscle, but it’s not a pure power grab. After all, investor protection, transparency, and fraud are legitimate issues that need to be addressed.

“Hedge funds require you to do your own due diligence, so anything that is imposed on hedge fund managers by the SEC as requirements for them to comply with can only be helpful,” argues Robert Levitt, a planner with Levitt Capital Management in Boca Raton, Florida. “There are some hedge funds that need more oversight. There are a lot of [hedge fund managers] out there who have put up their shingles without [meeting] any requirements.”

Jack Gaine, president of the Managed Funds Association in Washington, D.C., welcomes Pitt’s probe, and says the tremendous growth of the hedge fund industry–in assets under management as well as in the number of funds and managers–has sparked an upsurge in fraud cases. “Some cases have made newspaper headlines, and [Pitt] seems to want to get a handle on that. I think he’s open-minded about it,” Gaine says. “I don’t see any preconceived result [to the SEC investigation].”

Jeff Joseph, managing director of HedgeWorld (and a regular contributor to Investment Advisor) says that any industry that experiences a sharp acceleration in growth is prone to problems, and the hedge fund industry–with nearly 6,000 funds and $600 billion in assets–has certainly seen its share: two or three fraud cases or manager blowups per year are commonplace now.

How Transparent?

The surge in fraud cases is the motivating factor behind the SEC’s study of hedge funds, Joseph believes, and not the popular issue of transparency. “There’s so much discussion about portfolio transparency. To many investors, it’s not particularly meaningful because look at the level of transparency investors have had with mutual funds in the past: a little Morningstar page that gives them top five holdings or style breakdown or sector allocations,” he says. “But transparency at the portfolio level in terms of looking at what the manager owns, even in the mutual fund world, that’s often 60 to 80 days behind.”

The real issue of transparency comes at the manager level, Joseph says. So HedgeWorld recently partnered with NCO Financial Investigative Services Inc. to create HedgeWorld’s Manager Background reports. “We decided to take an investor advocacy position with respect to transparency as well, but from a different perspective,” he says. These reports enable investors “to really know who their manager is and make sure there isn’t any prior incidence of financial malfeasance or fraud or bankruptcy or judgments, any type of financial deed that would be material to an investor’s due diligence.”

Joseph says he’s all for the SEC’s regulatory arm reaching far enough to help guarantee investors quality products. But he’d be concerned if that authority stretched into areas that tamper with the hedge fund industry’s independence. “Hedge funds are this great bastion of capitalism,” he says, “and one of their great advantages is their low barriers to entry, which can also be a disadvantage–anybody can get the business, but not anyone can stay in the hedge fund business. The fees are higher, and only those who deserve these fees hit the critical mass that allows them to be successful hedge fund managers.”

The higher fee structure and low barrier to entry tend to attract the best and the brightest to the industry, Joseph says, and any missteps the SEC might make to interrupt this inflow of managers would prove detrimental to investors. “The advantage of the hedge fund arena is the great talent pool; you don’t want to dissuade the talent from entering.”

As for marketing of hedge funds, Joseph says registered products offering lower minimums are popping up left and right, ushering in a “retailization” of hedge funds. But he hasn’t seen “any aggressive marketing going out to unaccredited investors.” Gaine concurs: “Hedge funds are limited, by and large, to accredited investors and qualified purchasers, and if they are being sold to others, that’s a violation of Regulation D.”

“The Weakest Link”

Planner Levitt, who has clients’ cash spread among 20 different hedge funds, has become perturbed with the wave of hedge fund managers and marketing firms for hedge fund firms who solicit business through walk-in visits. He shies away from such managers, whom he calls “the weakest link in the hedge fund chain.”

But Joseph says this attitude is shortsighted, and that “advisors are smart enough to know that one or two hedge funds that knock on their door represent only one or two out of a universe of 4,000 or 5,000.” And uninvited hedge funds require the same due diligence measures as those funds that advisors have chosen themselves, and they can turn out to be sound investments, he says.

ETFs, meanwhile, have piqued the SEC’s curiosity of late, largely because of their huge growth. There are now more than 100 of them, with close to $90 billion in assets. The SEC is being called on to bless new versions of ETFs, ones matching the returns of fixed-income indexes as well as actively managed ones, and is pondering how to regulate these vehicles. The SEC gave an okay in May to Barclays Global Investors to launch seven ETFs based on bond indexes. The ETFs should be available this month.

The SEC says it wants to get a clearer picture of fund distribution practices and proxy voting by investment advisors. But Lee Kranefuss, CEO of individual investors business at Barclays, believes it’s a matter of time before the commission gives a nod to actively managed ETFs. “When it comes to any new product innovation, in the ETF arena or anywhere, where there is a compelling value proposition it’s a matter of when and not if,” he says.

SEC approval of Barclays’ fixed-income ETFs was a step forward in the development of these instruments. The assent was pretty easy to come by, since the fixed-income ETFs operate in a similar fashion to equity ones.

One of the great advantages of fixed-income ETFs, Kranefuss says, is that the package of bonds will be trading all day on equity markets. Bond ETFs, he says, “take a lot of the transparency of the equity market and make that available to bond investors.”

Tricky Business

But actively managed ETFs will be trickier to regulate. Pitt, in his speech at the ICI conference, said he’s concerned about “whether arbitrage mechanisms for actively managed ETFs are effective in moderating any premium or discount to a fund’s NAV.” When considering an active fund, “you open a completely different can of worms because in an index fund, there’s no reason not to publish the basket [of stocks],” Kranefuss explains.

Advisors like Barclays ETFs, called iShares, Kranefuss says, because they are getting professional management and diversification while simultaneously knowing exactly what they own. “They can go on to our Web site and look up [the ETF] and find out how it overlaps with other holdings in their portfolio,” he says. “Transparency is one of the greatest benefits to financial advisors.”

But with an active strategy, “a manager usually considers having to reveal twice a year what the portfolio holdings were to be a terrible problem–a violation of privacy and an opportunity for competitors to copy it, or to position against them,” Kranefuss says. “So there’s a real public policy issue.”

“There is a conundrum,” he adds. “There is clearly a reason in traditional active strategies not to share information as freely as has typically been the approach with ETFs, and which keeps ETFs tracking at a fair value,” he says. So the question is, “How much disclosure would hurt the active strategy, versus how much disclosure is needed in order to ensure people are getting fair prices?” Finding a way to make that all come together is what the ETF industry is grappling with now.

Melanie Waddell

Melanie is Washington Bureau Chief, Investment Advisory Group. She also covers regulatory and compliance issues and writes The Playing Field column and Human Capital briefing. Reach her at mwaddell@alm.com. On twitter: @Think_MelanieW

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